Did I put too much into my solo 401k?

I run a software consulting business with a net income of about $160k. My LLC isn’t filed as an S-corp since I have a W-2 job that already takes me past the Social Security cap. I planned to file as a sole proprietor. But I mistakenly thought the employer contribution limit was 25%, not 20%, and ended up contributing $40k instead of $32k to my solo 401k.

If I file as a sole proprietor, it looks like I overcontributed by $8k. Is that correct? If so, what should I do to fix this? I’ve heard about late S-corp elections and options for returning excess contributions. Are there penalties if I return the excess within the same year?

You’re misunderstanding how the “25%” works.

For employer contributions, the percentage is based on compensation excluding the contribution itself. So for sole proprietors, it’s effectively 20%, not 25%.

Example: If your net earnings minus half of self-employment tax is $160k, you can contribute $32k as an employer contribution, which is 20% of $160k. But that $32k is also 25% of ($160k - $32k), which is $128k. The same math applies to S-corp earnings, but with added payroll taxes and costs.

@Mildred3
Ah, I get it now. Thanks for explaining. I guess I need to remove the excess contribution unless I can make another $40k in net income soon (lol).

Do you know if correcting this in the same year avoids penalties? I found info about excise taxes for uncorrected overcontributions but nothing clear about penalties for fixing it immediately.

@Vern
Was the excess specifically marked as an employer contribution? If not, you could label part of it as employee deferrals instead. If you end up with excess employee deferrals, those can be returned under 402(g).

Otherwise, you might need to deal with the 10% excise tax and carry the deduction to a later year.

Check these resources:

@Mildred3
Yes, it’s marked as an employer contribution. I use Fidelity for my solo 401k, and they require you to mark it at the time of contribution. I’ll check if they can adjust the designation.

Vern said:
@Mildred3
Yes, it’s marked as an employer contribution. I use Fidelity for my solo 401k, and they require you to mark it at the time of contribution. I’ll check if they can adjust the designation.

Fidelity reps told me they can make those adjustments if you call them. Worth a shot!

Vern said:
@Mildred3
Yes, it’s marked as an employer contribution. I use Fidelity for my solo 401k, and they require you to mark it at the time of contribution. I’ll check if they can adjust the designation.

Are you already maxing out your 401k at your W-2 job? If so, you can’t make employee contributions to your solo 401k.

@Deductable
I’m close but not quite there—I’ve contributed $19,400 out of $23,000 at my W-2 job.

Vern said:
@Deductable
I’m close but not quite there—I’ve contributed $19,400 out of $23,000 at my W-2 job.

So, even if you reclassify the excess as employee contributions, you don’t have enough space left to absorb all of it.

Switching to an S-corp probably wouldn’t help. The limits would stay the same, and you’d lose some of the income to payroll taxes. For example, to make a $32k employer contribution, your W-2 salary would need to be $128k out of $160k profit.

Are you maxing your 401k at your day job?

Remember that for sole proprietors, the employer contribution limit is 20% of (net income - 1/2 SE tax).

Here’s the math for your case:

  • Net SE income: $160k
  • SE tax: 2.9% x 92.35% x $160k = $4,285
  • Half SE tax: $2,143
  • Max employer contribution: 20% x ($160k - $2,143) = $31,571

If you contributed $40k, the excess is $8,429.

For sole proprietors, the limit is 20%, not 25%. You can request a return of the excess contribution from your plan administrator. Otherwise, you’ll face a 6% excise tax each year until it’s resolved.

Rey said:
For sole proprietors, the limit is 20%, not 25%. You can request a return of the excess contribution from your plan administrator. Otherwise, you’ll face a 6% excise tax each year until it’s resolved.

401k plans don’t work like IRAs. Excess employer contributions to a qualified plan are taxed differently.

Section 4972 imposes a 10% excise tax on nondeductible contributions to qualified plans.

Here’s the IRS guidance: Instructions for Form 5330 (12/2023) | Internal Revenue Service

@Mildred3
Thanks for pointing that out. Good to know.